Reflections on White Collar Crime and Federal Criminal Law

Menu

The Definition of Fraud

Considering how important the offense of fraud is to white collar crime, you might expect the definition of fraud to be pretty clear by now. But a recent interesting case out of the 11th Circuit highlights the ongoing occasional uncertainty about what constitutes criminal fraud. It also highlights the risks of going to a bar with a stranger – but I digress.

Fraud is at the heart of much of white collar criminal law. White collar crimes, by definition, typically involve taking a victim’s money or property through some kind of deception rather than by force or violence. That same concept – wrongfully obtaining property of another through a trick or scheme – is also the essence of fraud. Any litany of the most common white collar offenses will include many with “fraud” in their title: mail and wire fraud, health care fraud, insurance fraud, securities fraud, real estate fraud, bank fraud, credit card fraud, and so on.

But fraud itself is not defined anywhere in the criminal code. As one federal judge helpfully observed: “The law does not define fraud, it needs no definition. It is as old as falsehood and as versatile as human ingenuity.” But of course we do need a definition, because human ingenuity also cooks up a lot of schemes that may be shady but are not criminal. Criminal law requires us to draw lines between conduct that actually amounts to fraud and conduct that may be merely dishonest or unethical — and sometimes those lines can be quite blurry.

Crimes such as robbery or homicide generally have pretty straightforward parameters. There may be defenses or mitigating factors in any particular case, but the facts that will establish the elements of the offense are usually relatively clear. If someone sticks a gun in your face and takes your wallet, there’s not much doubt there has been a robbery. If you come home to find your front door broken and all your valuables missing, there has been a burglary. But as I discussed in my last post, white collar crimes frequently involve more gray areas. The ancient crime of fraud is no exception.

In the absence of a statutory definition, the parameters of criminal fraud have been explored over the years in judicial decisions, with courts suggesting various formulations. The Supreme Court has said that to defraud typically means to deprive someone of property “by dishonest methods or schemes,” and typically involves “the deprivation of something of value by trick, deceit, chicane, or overreaching.” Another common formulation characterizes fraud as conduct that violates the sense of “moral uprightness, of fundamental honesty, fair play and right dealing in the general and business life of members of society.”

The trick, of course, is that not everyone will always agree on what constitutes “fair play and right dealing,” and mere “dishonesty” is generally not a crime. As I frequently remind my students, there is a lot of sleazy, rotten, immoral stuff that goes on in the world that is not criminal. White collar criminal law frequently involves trying to figure out the distinction.

Charles Ponzi

The Textbook Example: The Ponzi Scheme

The textbook example of a fraud is the Ponzi scheme, named for its most famous practitioner, Charles Ponzi. In the 1920s Ponzi came up with an scam involving purported trading in International Reply Coupons (IRCs). IRCs were certificates that could be purchased in one country, enclosed in an international letter, and then be redeemed by the recipient in another country for the postage necessary to send a reply. Ponzi claimed that he could double investors’ money in just a few months by buying and selling large quantities of IRCs and taking advantage of differences in international postage rates and currency exchange rates. Early investors received substantial “returns” on their investment; word quickly spread and the money poured in.

In truth, of course, Ponzi was not investing in IRCs at all and was simply keeping the money. If any investors wanted to withdraw some of their funds, he would pay them off using money he had taken in from other investors – a central characteristic of what we now call a Ponzi scheme. Most investors, seeing the impressive returns they were supposedly earning, were happy to keep their money with Ponzi and to send even more. People mortgaged their homes and sent Ponzi their life savings. He made millions within the space of a few months. But ultimately the scheme collapsed, the investors were wiped out, and Ponzi was indicted and sent to prison.

Nearly a century later, Bernard Madoff was convicted for the largest single investment fraud in history, costing his investors billions of dollars. His New York company, Bernard L. Madoff Investment Securities, LLC, was simply one giant Ponzi scheme that he ran for decades. The classics never grow old.

Examples like Ponzi and Madoff are easy; no one doubts that their actions constituted fraud. They stole money from their investors by lying to them, harming their victims through a “dishonest method or scheme.” But some other cases are not so clear.

Suppose you walk into my electronics store wearing a Donald Trump t-shirt and a red “Make America Great Again” baseball cap. While you are looking at television sets, I point out a yuuge, 110-inch flat screen and say, “Guess what? This is actually the same kind of TV set that Donald Trump has in his private suite at Trump Tower!” Although it’s a perfectly good television set at a fair price, I actually have no idea whether Trump really owns it. If you buy the TV based on my statement, have you been defrauded?

Or suppose I’m a real estate agent showing you houses, and I tell you, “The houses in this neighborhood really hold their value. They should turn out to be great investments for the people who buy here.” In reality, I know the housing prices in the neighborhood have been declining and people are bailing out. If you buy, relying in part on my statements, have I defrauded you, even though you end up with a perfectly good, habitable house?

Or suppose I set up a website offering to sell $50,000 tickets on a private space flight to go visit the aliens who abducted Elvis. I get a few takers among rabid Elvis fans living near Graceland. If I abscond with their money is that a criminal fraud, even if no reasonable person could have possibly believed the offer was real? Or should the law say the victims should have known better and can simply sue me in civil court to get their money back? Does the answer change if the tickets were only $500? $5?

The Definition of Fraud

One well-known case exploring the parameters of criminal fraud is United States v. Regent Office Supply Co., decided by the U.S. Court of Appeals for the Second Circuit in New York in 1970. Regent sold office supplies through salesmen who solicited orders over the telephone. When they called a prospective customer, the salesmen would tell various lies about why they were calling; for example, they would falsely claim they had been referred by an officer of the customer, or that the salesmen had stationery they could offer at a good price because another customer had died. They used these false stories to “get their foot in the door;” to get past the receptionist who answered the phone and speak to someone who could actually place an order. Once talking to that person, however, there were no lies — the price and quality of the merchandise was honestly discussed, the products sold were perfectly good products at a fair price, and the products could be returned if the customer was not satisfied.

The government charged Regent with multiple counts of wire fraud, based on the phony stories told during the initial phone conversations. Prosecutors argued that the customers were deprived of the opportunity to bargain with all of the true facts before them. The agents deceived the customers about who they were and why they were calling, causing the customers to enter into the transactions under false pretenses. Were it not for the lies, the sales would not have taken place. The government argued that this amounted to a scheme to defraud. The trial judge agreed and found Regent guilty.

The Court of Appeals reversed the convictions. The court noted it did not condone the deceitful conduct, which it said was repugnant to “standards of business morality.” But simply because it was repugnant did not mean it was fraud. Although the customers may have been deceived, the court held, they were not defrauded.

The government’s position was that fraud could exist in a commercial transaction “even when the customer gets exactly what he expected and at the price he expected to pay.” The court was not willing to go so far. Fraud, the court said, requires that some actual injury to the victim be at least contemplated by the schemer, and that was missing here. The misrepresentations by the Regent salesmen did not go to the quality, adequacy, or price of the goods. When the deal was concluded the customers had gotten exactly what they expected.

To constitute fraud, the court held, it is not enough that there be some deception involved somewhere in the transaction. The deception must be coupled with a contemplated harm to the victim that relates to the very nature or heart of the bargain itself. Any intangible or psychological “injury” that may have resulted here from the customers being deceived about the reason for the sales call was not the kind of injury that would support a criminal fraud conviction. The sales tactics may have been sleazy and unethical, but they were not criminal.

“Buy Me a Drink, Mister?” United States v. Takhalov

This distinction between being defrauded and merely being deceived still rears its head in cases today. This past summer, the U.S. Court of Appeals for the 11th Circuit addressed it in United States v. Takhalov. The defendants in Takhalov were owners of several nightclubs in South Beach, Miami. The clubs hired Eastern European women to pose as tourists, locate visiting businessmen, and convince them to accompany the women into the bars owned by the defendants. The defendants did not deny this was taking place, nor did they deny that the women concealed their relationship with the clubs from the men – in fact, they argued this was a perfectly legitimate business model.

The parties differed about what happened once the men were inside the club. According to the defendants, the men simply purchased food and alcohol and had drinks with their female companions. The government, on the other hand, contended that once inside the club other misconduct took place, including concealing the true prices of drinks and food, forging the men’s signatures on credit card receipts, and secretly adding vodka to the men’s beer so they would get drunk faster. The defendants claimed that if any of that was going on, they knew nothing about it.

The legal issue in the case was right out of Regent Office Supply. The government argued the jury could have convicted the defendants of fraud based simply on the lies the women told the men to lure them into the bar in the first place, regardless of what happened after the men got there. Had the men known the women were actually club employees rather than simply friendly strangers, they would not have entered the club. Any business conducted in the bar, therefore, took place under false pretenses and amounted to fraud.

The defendants, on the other hand, argued that if all the government proved was that the men were tricked into entering the bar, then the men would have been deceived but not defrauded. Although the women might have concealed their relationship with the club, once inside the club the men ordered food and drinks off the menu and got exactly what they expected to get at the price they expected to pay.

The Eleventh Circuit agreed with the defendants. The Court noted that the wire fraud statute “forbids only schemes to defraud, not schemes to do other wicked things, e.g. schemes to lie, trick, or otherwise deceive. The difference, of course, is that deceiving does not always involve harming another person; defrauding does.” A scheme to defraud, the court said, must involve misrepresentations that go to the nature of the bargain itself – usually lies that go to either the value or the characteristics of the goods in question. But if the defendant lies about something else, such as the reason he is willing to enter into the bargain at all, those lies will not amount to fraud — even if the victim would not have entered into the transaction otherwise. The victim in such a case is not injured in a way the law of fraud will recognize.

Just as in Regent, therefore, even if the “customers” in Takhalov were misled about the reason for beginning the transaction (entering the bar), once there, according to the defense, the men got exactly what they expected – food and cocktails with attractive women — at the price they expected to pay. Any misrepresentations that took place when the women concealed their relationship with the bar did not go to the heart of the bargain with the bar itself. The defense was entitled to have the jury instructed that if this was all the defendants did, they were not guilty of fraud. Because the jury instructions failed to make this clear, the court reversed the convictions.

Other Upcoming Issues in the Law of Fraud

As Takhalov demonstrates, the exact parameters of the offense of fraud continue to be litigated. In fact, in its first week of arguments this term, the U.S. Supreme Court is going to consider two cases involving different aspects of fraud. Shaw v. United States involves the proof required to establish bank fraud, and Salman v. United States, a case I wrote about here, will examine the elements of insider trading, a particular variety of securities fraud. I’ll have more about those cases in future posts, as the law of fraud continues to evolve.

Stay tuned – and stay out of South Beach nightclubs.

(Update: since I wrote this post the Supreme Court has decided the Shaw and Salman cases. You can find my Shaw here post and my Salman post here .)